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Subprime Crisis

How it all started - low interest rates period

Remember the dot-com boom and bust? In late 1990s and early 2000s, stock markets in USA reached their historic highs making an overwhelming impact on almost every stock exchange. This was aided by unrealistic valuations of Internet companies. It was essentially a bubble, which ultimately burst during the spring of 2001. The market crashed all around declaring numerous companies bankrupt; this sponsored an extensive loss of jobs and a very real fear of economic recession in the US, which was further compounded by 9/11.


The Lower Interest Rate Saga

In order to prevent an economic downturn, the Fed Reserve (Fed) started to reduce its lending rates. A reduction in Central Bank’s money lending rates to other banks causes a diminishment in value of funds as well. The lower cost of funds helps banks in a lower-rate lending to businesses and consumers. This leads to a greater economic activity as businesses increase bank’s investments and consumers increase expenditure of the financial organization. This approach to boost economic activity is called Monetarist Approach (essentially increasing the supply of money).

Hence, the Federal Reserve reduced its lending rate from an average of 6.4% in Dec 2000 to 1% in Dec 2003. It had the desired effect, as commercial and consumer lending picked up and US economy avoided recession. Though, the low interest rates regime also indicates that banks are lacking borrowers. To cope with the pressure of more business generation, a new section of borrowers was endowed with loans; this new group was introduced as the sub-prime category.

Reckless Lending

Sub-prime means ‘less-than-prime’ or in a more practical way it stands for ‘risky lending’. In normal circumstances, the sub-prime borrowers would not be able to receive loans from banks. Yet, with the interest rates at historic lows (basically, cheap money), many banks come forward to offer loan to these borrowers for buying homes (mortgage in US parlance). Most of these borrowers had poor credit histories, many were recent immigrants to the US, and indeed, there was a category of buyers called NINJA (No Income, No Job Also).  These buyers were lured into borrowing by extremely favorable initial payment terms. This was followed by an idea of a great boom in real-estate prices later, which could propel them to avail further loans. Shortly it became a self-fulfilling prophesy, as low interest rates resulted in more home purchases that caused an unexpected hike in its price. The strategy was continued, as they kept lending on lower rates followed by appreciation of property prices.

Reckless Lending- The Next Picture

In a bid to regulate this irresponsible lending procedure, Fed started increasing its interest rates from July 2004, which provoked mortgage organizations to increase their rate too. Consequently, the rate kept increasing till it hit a high of 5.25% in July 2007.

Now the situation of a mortgage borrower became terrible… The higher interest rate settled background for an increased EMI. (First two years were a payment holiday in most of the cases.) This hike in interest rate dropped off the demand of mortgage too, which tended to a great reduction in property prices. At this instant, borrowers were not even in the condition to sell their property to pay the loan amount. Hit by this double whammy, these borrowers were left with no option but to default on their payments and foreclose the loan, which brought down property prices even more (supply of homes became greater than its demand).

Now it comes to lenders, what happened with them? Well, many of them were saddled with bad debts in their books, and had to declare bankruptcy. They had violated basic risk management principle by lending money to borrowers, who have no ability and willingness to pay back. Therefore, it was an expected outcome.

Though, mortgage banks were highly affected by large number of home-loan defaulters; it caused almost same impact on non-mortgage banking organizations. Read on to get a detailed information-

Impact on Non-Mortgage Banks

Bank A can be taken as an example; this bank is primarily into mortgage business – it provides home loans. To provide loan, bank needs money which can be generated through accepting deposits from public/investors (capital) and operations (say profits from treasury operations). Evidently, if it can increase cash generation, it can also increase the amount it lends, and hence it’s a profit making deal.

In order to increase its cash generation, bank A started selling (issuing) securities whose cash flows were supported by its underlying portfolio of mortgages. These were called mortgage-backed securities, and they worked as follows – bank A had several borrowers, who would repay a certain amount every month/quarter. These would form the projected cash inflows. Bank A would then sell securities to other banks/financial institutions/corporate (Bank B) whose repayment would be tied to these inflows. A holder of these securities, Bank B, would be “assured” of getting his money back because bank A would be getting money from its mortgage buyers.

Clearly, if the mortgage buyers are unable to repay, bank A does not get anything. And if bank A does not get anything, it cannot repay bank B. And suddenly, Bank B is left with a bad loan in its records, thanks to the sub-prime lending in mortgage sector, even if it has not directly financed a single mortgage.

Here, the question arises, “why would Bank B buy mortgage-backed securities if the cash flows were at risk”? It would not, but due to a complex financial engineering, these securities were fixed in accordance with rating provided by famous credit rating agencies such as Moody’s and Standard & Poor (S&P). These agencies perform financial research and analysis of commercial entities. These agencies were lured by mortgage organizations and a good portfolio of Bank A was presented to Bank B. Perceptibly, this resulted in commonly referred terminology of risk management terminology as Moral Hazard, which reduced rigor in decision-making (greater risk-taking) since the decision maker had no idea of the final outcome.

At its peak, the US mortgage-backed securities market was worth $6 Trillion; this was the largest part of entire $27 trillion US bonds markets. The value of US mortgage-backed security market is considered bigger than the Treasury bonds issued by the American government.

This was the mortgage saga of USA and few European countries; these nations are crammed with financial organizations which have bad loans in their records and looking forward for massive capital injection to continue operations. Nevertheless, many institutions have received financial aid from multiple sources but those who couldn’t avail it, are collapsed.

Subprime Crisis: Impact on Overall Economy

Broken down by serious mortgage collapse, US economy was experiencing a great slowdown in its real-estate market too. Holding 15% of entire national economy, property market deceleration made its impacts on other industries also. Few industries such as home appliance market, DIY stores are directly linked with property market; hence, a real-estate slowdown influenced all of its associated industries.

Taking lesson from previous records, banks have become much more cautious in lending money (return to the basics of risk management); consequently, credit card or a personal loan availing procedure became more difficult. This made clear impacts on the purchasing power of an average US consumer, which further affected the sinking US economy.

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